9. Crude and Rude: Commodities, Bonds, and Everything Else You Should (and Shouldn’t) Buy

“[Gold] gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”

Warren Buffett, 1988

When people forget the past, they’re doomed to repeat it. In financial markets, they repeat it with other asset classes.

Amid the stock market turmoil of 2008, commercials began appearing on CNBC for brokerage Lind-Waldock. “Bought the wrong stock again,” a sad, morose looking guy says to a friend. She advises him to invest in commodities. He moans something along the lines of, “What do I know about pork bellies?” but she sets him straight, telling him to trade what he knows: “You know crude oil, right? Gold? With commodities there’s no P/E ratios or CEO scandals—it’s a pure price play.” A later commercial brings in a smug guy who asks his dopey buddy, “You’re still trading stocks?” Maybe that’s a legit question but he obviously advises his friend to trade commodities, not back off and just stick with long-term investments.

People are gun-shy when bitten, so they usually don’t make the same mistakes with something that’s lost them money. Often, though, they perceive the problem to be with the underlying investment and not the action they’re taking. So mistakes are made again, and commodities are a recent fad.

With growing interest in oil, gold, and other commodities, and easier facilitation for investing in these asset classes through lower account minimums or, more importantly, exchange-traded funds, suddenly the idea of investing in energy and metals, emerging markets, hedge funds, real estate, and all sorts of other assets outside of bonds and stocks has become a reality for individuals. With that came, of course, the marketing campaign, such as the one Lind-Waldock settled on, where the essential message was: “Investing is still easy—you’re just buying the wrong stuff! Instead, buy our product, because we know better!” The advertisements in question play to both the vanity of the individual investor and attempt to flatter you, putting forth the idea that yes, you know what you’re doing, but you just got screwed by those other guys. In addition, buying this asset class is easier than the other one—no fundamentals, just prices! Just things that go up! The tone is reminiscent of George Carlin’s comedic routine about the difference between the endlessly complex game of football and the blindingly silly game of baseball, where the only objective is to “go home. I’m going home! Wheeee!” This is sort of like that. “Prices go up, and that’s good! Yay!” You feel empowered by this commercial—after all, you’re an investor, so this should be easy, right?

And with that, the practice of cajoling investors into seemingly simple decisions asserts itself again. Commodities have become a popular alternative investment category because they’re one of the few that have emerged in recent years that truly qualifies as another asset, unlike hedge funds (which are just investment vehicles buying other things) or funds-of-funds (same thing). There are a number of raw materials that have been consistently strong performers over the recent years, but what’s more important is that they have generally showed a low correlation with stocks or bonds, which again means that they’re going to go a different direction than stocks or bonds.

Professional investors have mixed views regarding the benefits of you or me investing in hard assets. On the one hand, they are notoriously volatile, prone to slipping into sharp bear markets without warning. However, they are generally less correlated with assets such as stocks. The GLD ETF sports a rolling three-month correlation with the S&P 500 tracking ETF of about 0.5, which shows it has had a reasonably solid relationship, but hardly moves in lockstep.¹ Historically, the asset correlation has been much lower, but it has increased in the last two years or so as monetary policy officials flooded markets with liquidity that has seemed to find its way into just about every financial asset. Oil historically held a relatively low correlation with stocks, but that relationship has become rather strong since the onset of the financial crisis in late 2008, and it has remained tethered to stocks since. It’s more than likely to separate at some point, but it’s unclear when.

It has not gone unnoticed by the mass investing public. The U.S. Oil Trust exchange-traded fund, which is run by Brown Brothers Harriman, was created in April 2006 as the price of crude oil rose to $70 a barrel. It eventually peaked at about $150 a barrel in the summer of 2008 when the rest of the world looked to be falling apart, and since then it’s been crushed, lately trading pretty much around the same levels as when the USO started. The fund has grown to about $1.68 billion in assets as of late April 2010.² Perhaps the USO is a great way to get exposure to the oil markets, but even those who got in at the beginning are taking it on the chin—at the end of 2009, the fund was down 41.7 percent since inception.

The USO ETF and similar products that track other funds also differ from stock or bond-based ETFs; in the USO, the investor owns the one-month futures contract, making ownership somewhat of a bet on commodities futures rather than the actual underlying product. And the weird gyrations that can take place in that market make it more difficult for investors to understand, says Scott Burns of Morningstar. “It’s based on a futures/derivatives-type strategy and that’s what people don’t understand,” he says.

The appeal of oil is easy to see: For a long time, individual investors were basically limited to stocks, bonds, or cash, or investing structures that invested in those three (and perhaps real estate). That’s not the case anymore. And while Lind-Waldock might want to suggest that the “pure price play” appeal of buying oil or natural gas or wheat futures makes it easier to do than buying stock, the reality is that those markets are prone to big shocks at random moments, particularly the less liquid ones, which is basically any commodity outside of oil, gold, silver, and a few other fuel markets. “There are so many exogenous events or factors that impact oil, and if you’re not looking at it every day and you miss something you could eviscerate 50 percent of your portfolio in a week if you’re levered,” says Chris Edmonds, who invests in commodities at FIG Partners in Atlanta.³

When it comes to popular commodity-related ETFs, though, the USO has nothing on the SPDR Gold Shares ETF, which tracks the price of gold and trades under the symbol GLD. If there’s any one ETF that is ripe for speculating, it’s this one, thanks to recent trends in the gold market. Investors rushed headlong into gold in the latter part of the decade, owing to several factors. One was the asset’s status as a safe haven in times of trouble. Another was the devaluation of currencies worldwide, which enhanced the appeal of a precious metal that has value in just about any country. And third, the simmering conspiracy theories about the end of the world sparked more interest in this “end of days” asset. Gold has certainly been on a tear—after years of fetching barely $200 an ounce, it has traded between $750 and $1100 an ounce for the better part of five years, owing mostly to increased speculative activity in the asset thanks to the growth of ETFs—the GLD in particular.

This ETF first showed up on the New York Stock Exchange in 2004, and was worth nearly $40 billion as of mid-February 2010 and traded on several exchanges. What’s more, it was the second-largest ETF in the world, trailing only the S&P Select SPDRs, which tracks the broad S&P 500 index.

Gold, in many ways, is the perfect example of the “plausible fad” that we associate with the ballyhooed promotion of the Nifty Fifty, the Dogs of the Dow, or other seemingly safe-but-risky investments. After all, gold actually does exist, and for years has been considered the ultimate expression of safety because it is assumed that in some sort of massive breakdown in modern economic society, gold, prized by many, would retain value for people when their banknotes suddenly were determined to be worthless. And there is an element of truth to that—from a theoretical perspective. The reality is, we’re so far from a breakdown to a barter-based economy that such discussions are foolish. Unfortunately, gold only has value because we as a general public say it has value—in the same way salt was once a valued and rare commodity. It does not have the industrial uses as do silver or platinum, never mind a more practical metal such as copper. In 2007, there were about 3,500 tons in identifiable demand, and more than 2,400 tons were used for jewelry and another 650 tons were used in “retail investment,” which means hoarding of bars or through ETFs, leaving about 450 tons used in electronics, dentistry, and other applications.

So most gold is used more or less for shiny objects, which is great, but cannot form the backbone of an investment strategy. (Tell this to a die-hard gold fanatic, and you’ll get a treatise on why gold is being systematically undervalued by world governments as a result of some sort of worldwide plot. You have better things to do than to listen to such nonsense.)

More evidence of gold’s status as the current plausible fad is the recent surge in advertisements from outfits nobody’s heard of suggesting people either start hoarding the stuff or selling it off for a great price. That does not speak well to its fundamentals. For instance, former baseball player Keith Hernandez may be a heck of a person, but what is he doing endorsing companies that buy or sell gold from retail customers? “When people make too big of a deal of certain things, you know there’s something wrong with it,” Edmonds says. “All these ads started popping up for the firms that trade gold—why did that happen? There’s a lot of momentum, and a lot of people talking about gold, and it could sucker a lot of people into it. You don’t see IBM advertising, telling people to buy their stock.”

The vaunted gold ETF has problems of its own that other ETFs do not, however. The tax rate for sales of long-term holdings of what’s known as “collectibles” is a hefty 28 percent instead of 15 percent for long-term capital gains, and you can get socked with that if you unload some of your ETF holdings that are in a taxable account (obviously a 401(k) plan is treated differently). “For regular accounts, for most investors, you want to stay away from the bullion ETF, whether it’s silver or gold,” says Thomas Winmill, president of Midas Management, which invests in metals and metals companies. Winmill’s a big metals guy, investing heavily in hard assets and mining companies, but he’s wary of investors putting their money in the asset class, figuring that many people who have real estate—that is, own a home—probably could live without hard assets like gold or silver. Those who rent, however, could probably afford to put 10 percent of their money in hard assets, although he tends to argue for mining company stocks (or in your case, an ETF), because the operating leverage of companies that mine gold, silver, or platinum means that when prices go up, their stocks will probably rise much more than that.

He believes the more natural time to invest in hard assets is when so-called “real” interest rates are negative, or headed in that direction thanks to rising inflation rates.⁴ Real rates are calculated by taking the benchmark bond rate—say, the ten-year yield—and subtracting the rate of inflation. As of early 2010, inflation was running at about 3 percent, and the ten-year was trading around 3.7 percent, leaving a meager 0.70 percentage point real rate. With inflation likely to head higher, the real rate will remain low or perhaps continue to diminish. As a result, bonds are losing money to inflation, making a hard asset that appreciates in price more valuable for the time being.

Regardless of this, commodities are definitely one of a few “other” assets outside stocks and bonds that represent a different asset class, and are generally uncorrelated enough to be worth one’s investment. When it comes to diversification, we’ve already talked about how other asset classes formerly went their own way, but have been tethered to the stock market in the last several years amid the ongoing boom-bust cycle. That does not mean emerging markets stocks, foreign stocks, international debt, or currency investments are suddenly not worth it because they have become more closely aligned with the U.S. markets. But they also don’t represent something fundamentally different.

Other Asset Classes

I would be remiss to not mention some of the other major assets that have emerged as investment possibilities. So what qualifies as another “asset class”? It has to be an end investment and not just an investment vehicle. Stocks are an asset class, and one can plausibly say that emerging market stocks can be considered separate from developed country stocks; the same goes with government debt, corporate debt, and emerging-market debt.

Real estate is certainly an asset class that has its advantages and disadvantages. It, too, appreciates more dramatically during times of price inflation. Whereas stocks are thought of as a decent way to protect one’s portfolio against inflation, the individual actions of corporate managers and growth trends for specific companies are part of the fundamental equation. Assuming a property is kept in good shape, it will generally rise with the fortunes of similar properties in well-located areas. The reality for many investors, however, is you can overdo it in real estate if you already own a home, tying much of your fortune to how the real estate market does if you eventually decide to sell your own dwelling. Additional investments in real estate will tether you even more to the real estate markets.

It’s worth dispensing with a couple of investments that aren’t worth as much time for investors because they’re really not asset classes, just investment vehicles that are buying other assets. If you’re rich enough to afford the management fees of a top hedge fund manager, you’re probably not reading this book anyway, but if you are, best of luck to you. Everyone else is not going to have the kind of capital available to really take advantage of a hedge fund, so you’re just buying management costs that will dilute your investment. With that in mind, anything that advertises itself as a “fund of funds” is something to be wary of—after all, it’s a fund (which charges you money) investing in funds (which charge money too), and if you’re being sold this by a brokerage, there’s another fee also. By the time you’ve gotten to invest anything, you’re already substantially in the hole.

Bond. Treasury Bond

The next most popular investment and often a primary component in a portfolio after stocks are bonds, for good reason. They’re guaranteed to return your principal if that’s your intention, with a (relatively small) return from the interest you get for owning the fixed income asset. Bond portfolios can also be constructed through direct purchases from the U.S. Treasury, which you can use to create what’s known as a “laddered” portfolio consisting of bonds of different maturities to help protect you against rising rates.

Bonds of differing maturities can also be looked at as distinct—short-term debt such as Treasury bills have certain advantages that long-term debt does not (because it matures more frequently), but also has disadvantages (generally, it is very low-yielding paper). And bonds are going to remain one of the more important asset classes in the average person’s portfolio, because they’re designed to return one’s capital rather than open it up to the possibility of outright losses.

As stated previously, the bond market had a nice run for, oh, the last 40 years or so, managing to outdo the stock market thanks to a horrific run for equities in the first decade of the nascent 21st century. Many investments were beneficiaries of the sharp decline in inflation that began in the early 1980s thanks to the policies of Federal Reserve chairman Paul Volcker, but corporate, high-yield, and government debt did especially nicely. With yields having reached historic lows in the last few years, the prospect of another two-decade run in bonds is slim. That doesn’t mean they don’t have some value as an investment—they do—but they’re not going to outperform.

Investors have gotten used to thinking of debt mostly in terms of the Treasury’s long-term obligations, ten-year notes and 30-year notes, which it issues to cover payments for government spending. But the Treasury sells a ton of short-term obligations—bills with maturities of 30 days, or 90 days, or six months, and one advantage to debt of this type is that in an environment where the economy begins to recover and inflation starts to rise, this debt will respond more favorably than long-term debt. Since long-term bonds mature several years down the line, a five-year note that carries a yield of just 3 percent is going to be an unfavorable investment if inflation rises to 3 percent or more—in fact, that five-year note is losing value. Now, all debt loses value when inflation is rising. Stocks are in some ways a better investment as the underlying company can respond to inflation by raising prices and therefore potentially earning more money (and stock prices, if they appreciate fast enough, can outrun inflation). But if there’s one type of debt that’s going to recover its value more quickly, it’s short-term debt—that is, certificates of deposit and money market funds.

When inflation rises, current investments lose their value. Throwing one dollar into a drawer for a year in a 3 percent inflation environment puts you in a situation where a $1 purchase in January would cost $1.03 in December—but your dollar is still just one dollar. And so it is with debt as well. The difference is that short-term CD rates can adjust pretty quickly to respond to rising inflation, and money market funds become immediately more attractive. So your holdings are still going to lose money on a relative basis with inflation rising, but not as much as long-term debt. “Anything in a rising interest rate environment is going to take a hit, but money markets are liable to start paying the best rates the quickest,” says David John Marotta. “The biggest advantage is that it does not go down in a rising interest rate environment and starts paying higher interest almost immediately.”

On some level, this is not an issue if you are what’s known as a “coupon clipper.” That is, you buy a bond for the coupon—a 5 percent bond, for instance, is going to give you 5 percent every year, and then at the end of five years, you get your money back. That’s a guarantee from the government and corporate issuers (although the risk of loss is higher with corporate issues). If you’re buying bonds directly from the U.S. Treasury (a nice, low-cost way of going about putting together a fixed-income portfolio), you can get the interest rate you want without worrying about losing principal. However, if you’re invested in a bond fund that is more than likely trading that debt back and forth, the chances of losing money increase with the prospect of rising inflation and falling debt prices. “If you need to sell [a longer term bond] you’ll take a loss on it,” Marotta says. “And if you had cash, you could get more for it anyway.”

There is another option available for investors: Treasury inflation protected securities, or TIPs. The value of these securities rises when inflation goes up, and so they’re designed to be a hedge against rising inflation. If the rate of inflation remains stagnant, there won’t be much of an additional return, but they’re a nice way to fill out the portfolio; they hedge against those investments that are going to definitely lose ground when inflation rises (such as cash, long-term debt, and a number of other kinds of bonds, as well as certain stocks), but they’re not going to suck away your returns in a strong environment for everything else. More companies are starting to respond to investor desire for something that protects them against inflation—American Century Investments recently announced the launch of a fund designed to protect against rising prices through buying TIPs along with certain stock classes and commodities.

I’m not aiming to go through every asset class for its positive and negative points, but one thing that investors should keep in mind in coming years is that unlike the early 1980s, when stocks and bonds were undervalued, or the early 1990s, when commodities and real estate were trading at discounts to historical value, the new decade has begun with many major asset classes trading at levels that can, at best, be considered fair value, but are more likely than not expensive when compared with historic trends. Stocks cheapened considerably in the 2008-2009 blowup, but with a 75 percent rally since, most of the bargains have been easily had. Bonds continue to yield very little, and some decline in prices is going to occur. Gold hasn’t been this valuable in three decades, and oil may not be at $150 a barrel anymore, but that doesn’t mean it’s cheap, either. Corporate and high yield debt also slipped in 2008, eventually trading at a bargain, but those assets rebounded in the great 2009 rally as well. Emerging markets are no longer as inefficiently valued, and many markets, such as China, Brazil, and India, are in the midst of bull runs that may last for a number of years—or could be interrupted by fallow periods lasting a few years as well. Real estate is coming off its most overvalued period in decades in the U.S., and that goes both for residential and commercial real estate properties; they’re all in a long, multiyear declining process. So what is cheap? Troubled companies and countries that are in danger of defaulting on their debt obligations—but they’re cheap for a reason. And cash, one supposes, but leaving it under the mattress isn’t any kind of strategy.

This chapter isn’t meant to scare you out of investing entirely. After all, it would be pretty ridiculous to claim that you shouldn’t buy stocks, and, oh, don’t buy anything else either. The fact is that to garner strong returns and still sleep at night, you have to diversify, and that may mean buying a number of already-expensive assets. However, not all of them will be pricey at once, and keeping a relatively balanced allocation to all of them will mitigate losses from those that fall short of expectations. We’ve already discussed how diversity doesn’t always save the day, but that’s in part because of ineffective diversification—divvying up your money into two asset classes (stocks and bonds) and then further into various subsets of the first one (stocks) isn’t enough, not when commodities, real estate, other types of corporate debt, and short-term debt are available.

It’s also because you and I aren’t proactive enough with our own investments, sticking to certain allocations and failing to alter them in any way. What the next several years are going to require is twofold: flexibility and an eye towards your costs of investment. There’s no such thing as a free lunch, but in a more regulated financial services industry that’s struggling to rebound from the go-go 1990s and early 2000s, there’s going to be certain bargains and ways to cut your costs. Some of these ideas are pretty rudimentary, and others were happened upon, but they’re all pretty simple to implement. Amid that it’s time also to get to the checklist—the list of things you need to do to put together a relatively well-balanced, diversified portfolio that you can rebalance on a periodic basis.

Boiling It Down

• Your portfolio isn’t complete without bonds. They’re not a panacea, but they do provide some diversification and reduce risk.

• Treasury inflation protected securities (TIPs) can help keep up with inflation.

• Consider adding some commodities to your portfolio, but be forewarned: They aren’t cheap, and the funds that invest in them often carry high costs as well.

Endnotes

¹ Assetcorrelation.com.

² United States Oil Fund, http://www.unitedstatesoilfund.com/uso-holdings.php.

³ Author interview.

⁴ Author interview.